1. Richard Portes

1.1 Origins and the extent of the crisis

The paper by Ben Cohen and Eli Remolona provides an excellent summary of the origins
of the crisis. I agree with their emphasis on three key factors. There was:
(a) financial innovation – with exceptional opacity of new instruments;
(b) low interest rates globally, which prompted a search for yield; and (c)
an environment of ‘ravenous’ risk appetites driven by problematic
incentives in various guises. The authors state that as credit risk problems
became apparent, they transformed into a liquidity event, leading to what they
claim to be the unique depth and duration of this crisis. The key to this is
the interaction between market liquidity and funding liquidity in the context
of maturity mismatch, with the potential for multiple adverse liquidity spirals
as laid out by Brunnermeier (forthcoming).

With this as background it is worth asking: what policy options might have worked
to prevent or mitigate the effects of the crisis this time around, if they
had been applied? There is some evidence that better regulation could have
stopped some excesses. One case is the Bank of Spain, which did not permit
abusive off-balance sheet exposures, the use of structured investment vehicles,
and the like. As a result, Spanish banks are in relatively good shape, despite
the bursting of the Spanish real estate bubble.

History teaches that the next crisis will not have the same origins. Because it will
come from somewhere else, policy-makers must avoid the mistake of ‘fighting
the last war’. Great examples of this kind include the portfolio insurance
problems of 1987, derivatives disasters in the 1990s, and exceptionally high
hedge-fund leverage associated with the LTCM crisis of 1998. All these evoked
‘suitable’ policy responses, so none was a source of the current
turmoil – which came nevertheless.

The main puzzle in my mind is the extent to which the current episode really constitutes
a financial crisis, rather than only a crisis for the financial sector. So
far, the effects on the non-financial sector and the aggregate real economy,
even in the United States, are far short of what one might expect from the
‘biggest financial crisis since the Great Depression’. It could,
in fact, be argued that commodity and food price inflation have been much more
important factors in driving the fall in growth rates – which still,
almost a year after the onset of the turmoil, does not amount to a recession.

In some respects the problems are similar to those faced in the latter part of 1998
– during which there was a major sovereign default and a spike in market
volatility that was just as great – even though the financial market
turmoil then was not as deep nor as long as the current episode. So we have
more puzzles: deleveraging has so far been much less than in previous episodes;
volatilities and indicators of risk aversion do not appear unusual in historical
perspective (even the peak of credit default swap (CDS) spreads in February–March
is not much higher than the 2002 peak); TED and LIBOR-OIS spreads are stubbornly
high despite exceptional liquidity interventions; and long rates have not risen
pari passu
with inflation expectations.

1.2 Policy responses

Part of the answer to these puzzles may be that policy has actively responded to
the financial turmoil. In particular, there have been cuts in monetary policy
rates; not by the European Central Bank, but they might otherwise have raised
rates in August 2007. There have also been major changes in the market operations
of central banks, a widening of the range of collateral accepted (though not
in the euro area, where it was already extensive), the creation of new facilities
(again not in the euro area), and swap agreements across countries. In addition,
there have been efforts to repair bank balance sheets. Policy-makers have acted
aggressively in their own domains. In many respects, however, there has been
a lamentable lack of policy coordination among the major central banks, sometimes
even vocal discord.

On the issue of write-downs and recapitalisation many questions remain. Why did the
banks not cut dividends quickly and substantially? Was there any pressure from
regulators to do so? To the extent that there has been action, the approach
has been piecemeal. Repeated write-downs have been largely perceived as lacking
transparency and have in many cases led to further falls in bank share prices.
Sovereign wealth funds, hedge funds and others who have invested new funds
have been burnt, so not surprisingly, there is a reluctance to invest further
in bank recapitalisation. All this has been partly caused, or at least exacerbated,
by mark-to-market accounting.

1.3 Capital market dysfunctionalities

I now want to turn to three types of problems in capital markets that have exacerbated
the turmoil. These are problems that policy-makers did not fully or properly
understand, so it is only now that they are attracting attention – but
perhaps not yet enough. The first of these is in the CDS market, which faces
considerable distortion. In particular, if current levels of CDS spreads were
accurate indicators of the probability of default, then many banks should be
pronounced dead. The problem is that this market started out with a view to
buying and selling credit protection, but it has now also become a vehicle
for speculation – the size of the market is an order of magnitude greater
than the underlying credit risks being hedged. The market now has also become
one-sided. Everyone wants to bet against the banks, but no-one wants to write
protection. And with limited supply and rumours fuelling demand, prices have
gone way up on thin and volatile trading. It seems clear that this is a highly
speculative market, and it is subject to some manipulation.

The abnormally high CDS spreads have become a major problem for the banks because
new bond issues have to be priced by reference to (and hence above) CDS spreads.
Given the current high spreads, these markets are effectively closed. It also
appears that hedge funds are ‘playing rough’, trying to make things
look worse than they actually are, thereby helping to drive spreads up even
further. Such a strategy can be combined profitably with going short in bank
stocks.

There is a vicious circle operating in this market. CDS spreads widen, investors
demand higher yields, the cost of capital rises and its availability falls,
balance sheets deteriorate, and CDS spreads widen further. What could be done
to fix this? Often discussed – including by Ben and Eli – is the
value of organising centralised clearing, thereby significantly lowering counterparty
risks. This falls far short, however, of the transparency and normalisation
of the markets that would come from requiring that they go onto organised exchanges.
If the specificity of many of these instruments precludes exchange trading,
then we should simply accept the cost of greater uniformity. Unfortunately,
any such initiative will be resisted by the investment banks, which generate
large profits precisely from the specificity and opacity of the current arrangements.
They are enthusiastically pushing for centralised clearing in order to circumvent
pressure for exchange trading.

The second problem plaguing capital markets is the application of marking to market.
Valuing assets at ‘market value’
in period of financial distress (when the market is not functioning) amplifies balance
sheet problems. It also inhibits reliquefaction of markets, because asset holders
will not want to sell at distressed prices if they then have to mark down their
entire portfolios to those prices. Another vicious circle can arise here, because
as hedge funds and others sell at distressed prices, banks are forced to mark
their books lower, requiring them to tighten credit and leading to a further
round of selling. Meanwhile, long-term investors do not enter the market because
they believe prices will fall still further. These problems are compounded
by the fact that many assets are valued with respect to credit derivative prices
(for example, the ABX index), which are highly volatile and appear to overestimate
probabilities of default.

It is less than 15 years ago that the Securities and Exchange Commission began to
require ‘fair value’ accounting. Fortunately, that was well after
the debt crisis of the early 1980s, when the nine New York money centre banks
found themselves with aggregate exposure to developing country sovereign debt
of about 250 per cent of their equity capital. If these assets had been marked
to market when Brazil, Mexico and others stopped paying, the banks would have
been ‘under water’ (assuming a market valuation of less than 60
cents on the dollar – which is not much below where they settled in the
Brady Plan, almost a decade later). The world financial system faced a serious
danger of collapse. What was the solution? Jacques de Larosière and
Paul Volcker saw the threat clearly and successfully pressed for forbearance,
that is, classifying this debt as being ‘held to maturity’. This
cannot be done nowadays.

Ben and Eli argue that ‘… suspending fair value accounting …
would do more to reduce confidence … than any short-term relief it might
bring … But there are legitimate questions regarding how to value assets
when markets are illiquid. In response … the International Accounting
Standards Board has established an expert panel …’. It will report
in due course. Meanwhile, I think it would be wise and not confidence-impairing
to limit the application of fair value accounting to assets on trading books,
while excluding assets which are bought to hold till maturity.

The third dysfunctionality I want to highlight is that of the (dis)credit(ed) rating
agencies (CRAs). The natural monopoly characteristics of this industry have
been enhanced by the dependence of regulators on ratings – that is, the
CRAs have been granted a ‘regulatory licence’. Pension funds, insurance
companies and others may invest only in securities given ‘investment-grade’
ratings by a small number of agencies specifically designated by the regulators.
But they are subject to considerable conflicts of interest, use models which
are suspect, produce ratings that are lagging indicators and add little, if
any value (Levich, Majnoni and Reinhart 2002). Ben and Eli tell us that ‘regulators
have begun to investigate the ways in which ratings are sometimes “hard-wired”
into regulatory and supervisory frameworks’. They also propose better
management of conflicts of interest ‘in line with the revised International
Organisation of Securities Commissions Code of Conduct’. The 2005 version
of the Code was fully implemented, however, with zero effect (see AMF 2008);
I would suggest that self-regulation is unlikely to accomplish anything.

So how else can the CRAs be dealt with? The heart of the problem lies in designing
a system with the right incentives. Normally public goods should have public
funding, but not here – there are obvious problems that would arise with
public involvement in ratings. I would argue that subscription (the pre-1975
model) should be revived, perhaps via a levy on users. We should also require
the agencies to provide more information regarding their judgments, including
an assessment of the liquidity characteristics of an instrument and the likely
volatility of its market price. Moreover, rating ranges should be provided
in many instances, in preference to point estimates. The business of providing
ratings should be separated from the advisory/consultative side of the business.
Most important, the ‘regulatory licence’ should be eliminated.

Let me conclude by commending Ben and Eli on their summary of the nature of this
crisis and the manner in which it has unfolded. I think that more work needs
to be done to address problems in the capital markets, which this crisis has
exposed. At the same time, we need to avoid merely ‘fighting the last
war’ by remembering that while all ‘… crises are the same
… All crises are different’ (Portes 1999, pp 471–472).

There is an alternative. That this conference session is being held on Bastille Day
brings to mind an admittedly radical policy – to ‘shoot the speculators’
(the guillotine being an outdated technology). The then French Finance Minister,
Michel Sapin, cited this historical precedent in his parliamentary intervention
on the crisis of the EU Exchange Rate Mechanism in autumn 1992. One can easily
imagine that it would be a popular policy now.

2. Grant Spencer

The paper by Ben Cohen and Eli Remolona provides a good overview of the current episode
of financial turmoil and is a useful introduction to what will no doubt be
an interesting conference. In my comments I would like to briefly discuss
the effects that the financial turmoil has had on New Zealand so far, and
its implications for the Reserve Bank of New Zealand (RBNZ, which is also
the prudential regulator). I think that this is likely to be of some interest
given that New Zealand's very open capital markets and relatively high
debt levels have presented some very specific issues in the current adverse
global credit environment.

Overall, New Zealand's financial system has so far withstood the global financial
turmoil well. This is partly because it has little direct exposure to the
mortgage market in the United States, and NZ banks have not developed the
complex structured financial instruments which have been a key contributor
to the recent turmoil. New Zealand has, however, been affected by the global
tightening of credit markets. So while the banking sector has not suffered
any shortage of equity, it has been affected by the tighter cost and availability
of debt. As defaults on US sub-prime mortgages have risen, liquidity in global
capital markets has become scarce. NZ (as well as Australian) banks source
a significant degree of funding from international capital markets (around
40 per cent of bank liabilities in New Zealand are external) and often at
short maturities. In both Australia and New Zealand, the spread to overnight
indexed swaps increased in mid 2007 and has remained well above its long-run
average, although it is worth noting that these spreads are not as large
as those in the United States and Europe.

The significant external exposure of the NZ economy is manifest in its sizeable current
account deficit, with a large share of the nation's external liabilities
held on NZ banks' balance sheets. Clearly, any disruption in the flow
of funds to NZ banks will be potentially disruptive for the macroeconomy.
In other words, a further tightening of global credit markets could have
significant implications for macrofinancial stability as well as the prudential
soundness of the banking system. Related to this, there is concern about
liquidity shortages in the foreign exchange market. Although the NZ currency
is presently above its long-run average, it has been below the level suggested
by the historical relationship between the exchange rate and the yield differential
with the United States.
The declining appetite for risk in global financial markets and the international
economic slowdown may put downward pressure on the NZ currency, which could
pose risks to markets and the economy if the adjustment is sharp.

The immediate policy response in New Zealand to the global financial market turmoil
has been to adopt a quite accommodating liquidity stance for banks. The RBNZ
implemented changes to its domestic market operations to ensure that banks
would be able to access liquidity should the credit squeeze become more acute.
The RBNZ increased settlement cash levels, narrowed the discount margin and
lengthened the discount window to 30 days. We also expanded the range of
securities we would accept as collateral to encompass NZ dollar, NZ-registered,
AAA-rated residential mortgage-backed securities.

The RBNZ is also currently undertaking a review of its prudential regulation, specifically
focusing on liquidity management by banks. It is likely that this review
will produce recommendations aimed at ensuring that banks lengthen the maturity
of their wholesale funding as well as diversify their sources of liquidity.
Given the reliance of the major NZ banks on short-term wholesale funding
from the international markets, I would expect that the new policy will require
more conservative liquidity profiles than we see at present. In implementing
the new Basel II regime, the RBNZ has focused on ensuring that bank holdings
of capital are adequate to withstand credit losses from a significant downturn
in the domestic housing market. In the current environment, this is a very
real risk over the coming year or two. The RBNZ will soon also have responsibility
for the regulation of non-bank deposit-takers
and the insurance sector. The relevant legislation is currently in the House of Representatives.
An important role of these regulatory frameworks is to provide buffers against
the sort of international financial shocks that we are now experiencing.

Finally, I would note that the credit creation process has been very procyclical
in New Zealand over recent years. Aggressive credit expansion by the banks
through 2003–07 contributed to the biggest housing boom seen in decades.
Subsequently, since mid 2007, credit standards have tightened sharply as
the housing market has turned down – particularly with the overlay
of tight global credit markets. Factors contributing to this procyclicality,
in my view, include asymmetric incentives facing bank management, mark-to-market
accounting, the new International Financial Reporting Standards provisioning
requirements, and point-in-time capital models. A potential response to this
could be a countercyclical prudential policy, which could operate by means
of the Pillar 2 supervisory overlay. Such an approach has been discussed
at earlier RBA conferences, along the lines of the work of Claudio Borio
and Philip Lowe. However, our own simulations suggest that the required moves
in capital ratios would be too large for practical implementation. The cyclical
component would swamp the prudential component, thereby undermining the original
rationale for the capital adequacy policy. An alternative could be a more
countercyclical monetary policy. However, as we have found in New Zealand
in recent years, this can also be very difficult if the domestic cycle is
out of sync with the global economic cycle.

3. General Discussion

The paper and discussants' comments provoked debate about the magnitude of the
2007 and 2008 financial market turmoil to date, and its likely impact on
the real economy. This was partly in response to Richard Portes's suggestion
that, on a range of metrics, financial conditions did not look as bad as
they had been during recent financial crises. Some participants thought this
view was too sanguine, suggesting that the decline in the US housing market,
according to some measures, had been greater than during the Great Depression.
In line with this, a number of participants suggested that – notwithstanding
the positive effect of recent policy responses – a substantial part
of the effect of the financial turmoil on the real economy was yet to materialise,
and that weaker economic outcomes (assuming they did occur) would lead to
further losses for financial institutions.

The discussion moved on to a debate about the causes of the recent financial turmoil.
Some participants suggested that low global interest rates early in the decade
and the extent of financial market innovation were both potentially factors
which led to and/or exacerbated the crisis. In particular, the creation of
some complex financial instruments had made risk exposures more difficult
to assess and added ‘opacity’ to some parts of the financial
system. One participant suggested that risk had become more concentrated,
not less, in part because the largest dozen banks in the world now handle
the bulk of the transactions, hold a large part of this risk, and operate
with similar business models. Consequently a problem at one major institution
can have global ramifications. More generally, participants argued that the
model of banking had changed in recent years, with many commercial banks
now operating in similar ways to investment banks, particularly in their
use of high-leverage strategies. This raised the general question of whether
it was appropriate for all banks to operate in this way. Other participants
argued that systems of executive compensation had also evolved such that
there were conflicts of interest in the private sector. This met with some
debate, as some suggested that private-sector agents needed to have more
‘skin in the game’, while others thought that recent large declines
in bank share prices and the loss of managements' reputation, by association
with any bank failures, were incentive enough to promote prudent risk management.
In response to the question of how problems in one part of the financial
markets could lead to the global turmoil, one participant suggested that
the underlying problem had been the house price bubble in the United States,
and the sub-prime mortgage problems were just one symptom of this much bigger
concern.

Much of the rest of the discussion was focused on the role of policy-makers in managing
risk in the financial system. One participant argued that a key goal for
macro-prudential regulators is to determine how to predict crises by identifying
events which might indicate the advent of a crisis. In this regard, a few
participants highlighted the importance of large increases in the prices
of assets, particularly those that form the basis of collateral and accompany
rapid increases in credit. With regards to potentially adverse structural
change, the institutionalising of mark-to-market accounting was raised as
a possible policy concern on a number of fronts. First, it was suggested
that accounting has become quite liberal and in some ways more art than science.
Second, there was some question about whether it should be the role of the
authorities to create markets where they do not exist, so that mark-to-market
accounting could work effectively. Related to this, there was a debate about
the role of central banks in becoming market-makers of last resort, with
the attendant moral hazard concerns. Some thought the moral hazard issues
were significant, while others were of the view that it had not been a major
problem in previous episodes.

There was a brief discussion about procyclical prudential regulation. Some participants
agreed with Grant Spencer's comments, suggesting that it was unlikely
that loan-to-valuation ratios (LVRs), or procyclical liquidity and capital
requirements could be implemented in a way that had a substantial effect
on reducing credit cycles. In response, Eli Remolona suggested an alternate
view, citing developments in Hong Kong in the early 1990s as an example of
the successful use of procyclical LVRs. Hong Kong's LVR was lowered significantly
during the run-up in house prices, which helped limit the extent of large
systemic problems and bank failures when house prices subsequently declined.